Great Transformation

Ten years and billions of dollars’ worth of investment in research and development have produced a real alternative to the traditional cigarette – IQOS – which is being purchased by an additional 10.000 people across the world every single day choice. It is estimated that nearly 5 million adult consumers around the world have already stopped smoking and switched to IQOS in 35 countries. At the vanguard of this transformation is Philip Morris International.

My smoker friends tell me that a cigarette and a cup of coffee is the best means of retaining clarity of thought. I am not sure, as I have never tried it myself. Out of fear of lung cancer, I never took up smoking, and I regard jokes about old grannies who smoked heavily and lived a long life rather silly (even though we all laugh about them).

In truth, ‘clarity of thought’ is irrelevant. The reasons for being attached to cigarettes are far more prosaic and physiological.

Smoking sends nicotine molecules directly to the brain within a few seconds. Thereafter, the nicotine attaches itself to the brain receptors, producing a wave of dopamine and other chemicals, which in turn stimulates the feeling of comfort and enjoyment.

Nicotine is not the only substance which causes addiction. Thus, research conducted by the University of Michigan shows that smoking also activates other molecules inside the brain, which not only stimulate positive moods, but also suppresses negative moods.

Today it is a matter of heated debate within the western medical circles, what causes greater addiction – nicotine, or other chemicals that are mainly produced during the burning of tobacco.

What we can say for certain is that smoking becomes a justifiable habit in the mind of a smoker, and that beating the habit is harder than acquiring it. Therefore, it would be logical not to expect a sharp decrease in the number of smokers over a short period of time. According to the World Health Organisation (WHO), a billion people will still be smoking in 2025, which is roughly the same number as today.

On the one hand, the WHO statistics are good news for the tobacco industry and its players. However, doing business in a strictly regulated environment is becoming increasingly difficult. Therefore, large companies are increasingly forced to think about ways to remain in business while offering customers less harmful products to reduce the weight of the regulator’s most effective leverage – caring for the smoker’s health.

Going through the scientific overview is not a waste of time. You only have to consider the choices facing the industry today: on the one hand, nicotine must stay, since it is indispensable and plays the central role in satisfying the smoker’s habit. On the other hand, based on the above, the aim should be to reduce the harmful impact of other elements, thereby diminishing the extent of addiction to the product and the potential damage to a person’s health.

None of the alternatives which failed to take the aforementioned terms into account have so far been successful. One such example is the electronic cigarette, which had the industry’s hopes attached to it, but ultimately was not accepted by the smokers, as it lacked a key component – real taste of tobacco and the ritual. Therefore, the industry’s last remaining hope of saving the business is attached to two of the most widely used terms of the 21st century – innovation and transformation.

Which innovations should we look out for? Various organisations ask this question each year and compose lists of all the many things that can turn our lives upside down and have a serious impact on us in various ways. At times, the extent of such impact has not been studied in full, but the changing trends are so strong that keeping an eye on them is a must.

CitiBank named the development of heat-not-burn tobacco technology as one of this year’s most significant trends, along with blockchain and modern DNA research. According to the publication, this is the most important innovation within the tobacco industry since the electronic cigarette.

The new devices heat up the tobacco without burning it. The smoking experience is not being diminished, since the smoker can still taste real tobacco (including nicotine), even in the absence of the pungent smell, fumes and ash. As the burning of tobacco is avoided, far less toxic elements are released, thereby potentially reducing the harm to the user.

The idea of heating the tobacco has been developed by the industry for several decades, but only during the past few years has it succeeded in releasing a product that is seemingly able to satisfy the smoker’s needs. That product is IQOS, and it is manufactured by Philip Morris International.

IQOS first went on sale in Nagoya (Japan) in 2014. Today, this innovative product is sold in 35 countries. Philip Morris claims that as of February 2018, around 10.000 people across the world were choosing IQOS over traditional cigarettes on a daily basis, while approximately 5 million people had already renounced traditional cigarettes completely in favour of IQOS. The majority of these people live in Japan, where the taste of menthol is being preferred to that of plain tobacco, and where new technologies are more readily accepted.

The IQOS device is composed of two parts. Whereas tobacco burns at a temperature above 800 °C inside a traditional cigarette, in the case of IQOS, the burning process is completely eliminated, while the tobacco is heated up to 350 °C. Furthermore, only vapor, rather than fumes/smoke, is released externally. Heating at a lower temperature releases the taste of the tobacco, but with far lower levels of chemicals than a traditional cigarette. Unlike its competitor (BAT has also introduced its product ‘glo’ on the market), this device does not allow smokers to immediately follow up one smoking experience with another, as it needs to be reloaded and recharged.

Philip Morris has been spending billions of dollars on research and development of its product to ensure greater reliability and accessibility of IQOS. More than 200 smoke-free-related publications and book chapters have been published by PMI the past ten years in peer-reviewed scientific journals; over 2,350 patents granted and over 3,750 pending patent applications for smoke-free-related applications granted to PMI which was the only tobacco company in the 100 top patent filers at the EPO (European Patent Office) in 2016; fifth among fast moving consumer goods companies.

The company’s short-term ambition is that at least one out of three of its consumers, 40 million men and women, will stop smoking and switch to IQOS by 2025.

IQOS is not yet represented in Georgia officially, but it is already being used by some people who usually buy the device and the accompanying small tobacco sticks abroad. It got me interested: why does Philip Morris not focus on this product in Georgia, if there is demand on the local market? In an exclusive interview for Forbes Georgia, Juan Carlos Escobar, the company’s representative in Georgia, devoted one and a half hours to answering our questions.

Do you think that the cigarette industry will change beyond recognition? In what ways do you see the new generation of innovative products altering the global market, and how long is this process likely to take?

If you look around, you will see that the latest technological advancements are fundamentally changing not only the tobacco industry, but many others as well. At last, new technology has become a full part of the tobacco industry, and I do believe that in the future, the industry will be completely different from when I started working here 14 years ago. I hope that these revolutionary developments will also affect Georgia soon. However, I must point out that the speed of this transformation is not entirely dependent on us. Governments and legislations have by far the biggest role to play in this regard. Some countries and governments are keen to open their doors to innovation, while others – for historical reasons, or in order to protect their local industries – may decide to slow down these changes, thereby involuntarily neglecting something that can be beneficial for parts of their populations, and to smokers in particular. Our company has been most successful in commercialising its products, including IQOS, in countries where regulatory frameworks and tax systems do not place equal constraints on traditional cigarettes and innovative products. You should also bear in mind that in spite of numerous counter-campaigns, regulations and tax increases, the WHO does not expect the number of smokers to decrease dramatically by 2025. In a parallel development, innovation has finally reached the tobacco industry, offering better alternatives to those who do not wish to quit.

Is this a real alternative? Has Philip Morris invested funds into research to determine whether these new products do indeed contain less risks?

We have a very detailed and systematic approach to research and development when it comes to the new generation of innovative products. This includes conducting regular clinical and behavioural studies. Our schemes are similar to those used by pharmaceutical companies to test medicines and we adhere to Good Laboratory Practices. In this regard, the company portfolios of these two industries are virtually identical. 400 scientists and engineers are involved in this process. They have access to the latest technologies in the most modern laboratories. As of today, we have the following results to show: (1) IQOS vapour contains on average 90-95% lower levels of toxic substances than the smoke of cigarettes which we used for comparison purposes; (2) laboratory tests show that IQOS vapour is significantly less toxic than cigarette smoke; (3) clinical tests (which are still ongoing) involving smokers who made a full switch from traditional cigarettes to IQOS have revealed a significant reduction in their exposure to 15 toxic substances which approached that observed in people who quit smoking for the duration of the study; (4) using IQOS does not negatively affect the indoor air quality, so it does not become a source of passive smoking; (5) our research shows low interest in IQOS among people who have never smoked. . We are using a transparent and confident approach towards science and research, and we publish our data online (www.pmiscience.com) for review. Research into the new generation of innovative products does not only interest us. The state health sector is also beginning to familiarise itself with the role of products containing lower health risks, with a view to reducing damage caused by smoking. For example, Public Health England has prepared a report on the advantages of electronic cigarettes over the traditional ones. We must bear in mind that public policy and legislation develops slower than technology based on market demand, but I am certain that over time, the former will catch up with the latter.

Let us talk about the market and about demand in greater detail. Do you view competition regarding the new generation of innovative products in global terms?

The speed of innovation is growing unbelievably quickly in every industry. The tobacco industry has traditionally been quite conservative ever since the natives of South America first started smoking centuries ago – even before my Spanish compatriots brought the tobacco plant to Europe. Today, innovation has finally reached the tobacco industry as well. All our main competitors have developed and introduced to the market certain products of the new generation. Strong competition is good, as it increases the rate at which new technologies are being incorporated into the industry, which is ultimately good for the smokers themselves.

Is this market growing in Georgia as well?

Lower-risk products and IQOS are the answer to the needs of smokers across the whole world. This is true for Georgia as much as it is true for the countries where the number of IQOS users is growing. This includes Japan, where the market is already quite large, but also Greece, Italy and Romania. To be honest, we know that people are already using IQOS on the streets of Tbilisi. I presume that they are buying this product on the markets where we have already managed to commercialise IQOS.

Who in Georgia can be regarded as a target consumer for IQOS?

As is the case with any revolutionary product of the new generation, the first versions of this technology are quite expensive for the average consumer in Georgia. However, I am certain that once we increase the scale of production and further develop the technology, we will be able to make the product affordable for smokers in all income brackets. At present, we can compare IQOS to the first generation of mobile phones, which were large, relatively basic and very expensive. Our goal is clear: we would like to see all smokers who cannot or do not wish to give up the smoking habit switch to the potentially less risky products. In future, the largest part of the costs will no longer be taken up by the device, but by the tobacco sticks. Taxes will also have a significant part to play in the pricing of the product. Therefore, governments across the world will play a big role in determining how affordable the alternative products will be for smokers, and how quickly the innovations can be implemented.

It must be difficult doing business in an industry which is strictly regulated across the world. How big is the tax burden in Georgia compared to the other countries where you are represented?

I would like to begin by saying that it makes sense to have strict regulations on a business such as ours, bearing in mind the risks associated with our products. The government has two ways of becoming involved: taxes and regulation. In Georgia’s case, taxes on cigarettes are considerably higher than in most other countries in the region. Around 70% of the average price of a pack of cigarettes (GEL 2.7) is taken up by taxes. I am not sure if the population is aware of this, but income from taxes on cigarettes makes up more than 9-10% of the state revenues. An increase in the excise tax can lead to legitimate business being replaced by smuggling. As for the general level of regulation in Georgia, I think that the new law adopted by the parliament last year, which is due to be gradually implemented from May this year, will push the relatively unregulated current environment straight into the other extreme. To be honest, we are represented in many countries across the world, so we will manage to adapt our business model accordingly, but it remains a mystery how a country can jump from one extreme to another. It is my personal belief that extremes should be avoided altogether. Nevertheless, the main problem with the new law is that it approaches the burning and heating of the tobacco in a similar manner. This differs radically from the frameworks adopted by developed countries. The United States, the European Union and the United Kingdom have already begun to understand that there are different ways of consuming tobacco, and that much better and less risky alternatives are now available for those people who cannot or do not wish to quit smoking. Even the WHO acknowledges that the number of smokers across the world will be roughly the same in 2025 as it is today. The smokers and the governments will lose out in a situation where people’s access to information about new and less risky products is restricted by regulation. The only winners will be the special interest groups that wish to continue selling traditional cigarettes. I can say this with confidence, as I represent the company which is one of the largest player on the market of traditional cigarettes in Georgia. Once the smuggling networks are set up, it will be very difficult to eliminate them. We put a lot of effort into helping governments fight contraband, but the economic incentives may be so big in this area that transporting cigarettes from one place to another may no longer be challenging. That is why it is so difficult to fight contraband. Smugglers are usually connected to criminal groups. As a business, we try to help governments as much as we can to uncover smuggling networks.

The attitude from our parliamentarians seems to be that smugglers can be dealt with, but health risks cannot. Why are you finding it difficult to convince them that the new generation of products contain less health risks?

If you look at the regulatory frameworks in the US and the EU, you will see it enshrined in law that convincing research results shall lead to the regulations regarding this type of product being reviewed. The US has a thoroughly professional and detailed environment which even allows for the commercialisation of the product. It is a very difficult process, but the process exists. As a rule, policy development always lags behind progress.

What conclusions should we derive from our conversation today? Is it easy to do business in Georgia?

With regards to many administrative components, doing business in Georgia is indeed easy. Starting a business and paying taxes is easy. Although the tax on tobacco is very high, this is not the case for other industries. I appreciate the government’s willingness to constantly improve the business environment and remain open to hearing and absorbing ideas from businesses. I think that Georgia has progressed a lot, but it is also true that some of the older and less transparent models of doing business still remain. This cannot be reflected in any international indexes, and it can considerably poison the business environment, as we experienced ourselves last year. We must always remember that the Georgian market is quite small, and in order to attract foreign investment, as well as retain professional and competitive local companies, the following two components are required as a minimum: strong, effective and independent state institutions and commercial agreements, as well as openness towards the rest of the world. I must say that the government is actively working on the latter. Of course, all of this is much easier said than done.

Let us briefly examine both of these components. Do I understand correctly that as a large player you would wish to have an environment where there is the EU Association Agreement, as well as a free trade agreement with China?

We can pull our weight internationally in any case, but for smaller companies that are looking for new markets, agreements such as these are vitally important. On the other hand, commercial agreements are the axis, while the devil is always in details such as the relationships between countries, institutions, banks that are prepared to fund import and export, and harmonised legislation. There may be an agreement in place, but many hidden barriers to trade could remain. It is good when the government listens.

Listens to whom?

To the business community and investors. I have worked in many countries, and I think that in Georgia there is a possibility for a good dialogue with the government. Of course, there are numerous issues where we must agree to disagree, but having a dialogue is important. Our industry, due to its controversial nature, represents an exception, but in general, the government’s attitude towards having a dialogue with the private sector is very significant.

The government often says that the income tax reform was a result of precisely this kind of dialogue. Do you benefit from this reform?

The reform was implemented during a difficult time for us, when we were going through a court case. On that occasion, the business environment was pushing us towards halting our investments, as the situation was very unclear – we did not know whether or not the court would protect us in a situation which was neither clear nor just. As an investor, you start thinking about how to save your assets in a situation like this, and you are guided not only by your own experiences, but also by past cases: how did the courts approach business-related disputes in the past, and what kind of decisions were taken? Therefore, we have not yet had a chance to benefit from this reform. In fact, it had a certain negative effect on us, as the excise tax on tobacco was increased to balance the budget, although I think that from a general economic perspective, this reform makes sense. However, this is not the main issue. The income tax rate is only one variable for a business which plans to invest and reinvest. The main factor is the sense of stability – a clear guarantee that the investments and assets of the business are protected. If that is not the case, then the income tax rate is probably irrelevant, as you would not risk investing either way.

You mentioned stability several times. Earlier you also spoke about dialogue with the government. When you talk about stability, do you also mean legislative stability? For example, did you know that the excise tax would increase twice in the space of a year, and were you prepared for this?

Yes, this is one of the types of stability that I was talking about, and no, we did not have any prior information about the excise tax increase. A predictable business environment is vital for any business. This does not mean that taxes should not be increased, but rather that there should be a certain degree of predictability about the process, so that the risk premium can be reduced, and the income levels can at least be estimated. Business does not significantly differ from real life. For example, if you want to buy a house, but cannot be certain that nobody will demand that the property must be returned afterwards, then you will not want to proceed with the purchase. That is all there is to it.

You represent the company which won one of the most famous court cases in Georgia…

When I arrived in Georgia a year ago, I had to deal with a situation whereby one of the local companies was accusing us of setting unfair selling prices for some of our products. We had a very strong legal position and immediately adopted a clear stance that we would not be giving up as that is not how we operate – in Georgia, or elsewhere. The main thing is that we won, and I am glad that our case led to the issues of judicial reform, the rule of law and just resolution of business-related disputes being placed firmly on the agenda of the government and international institutions. I personally admire the work carried out by Transparency International during this period. I am grateful to our head office, as well as all our employees across the world who were supporting and encouraging us. Clearly, it was a difficult period. We were under a lot of stress, but we won. As is the case in real life, gaining trust is difficult, but losing it is easy. A few negative experiences are enough to destroy trust. In any case, we hope to have turned this page.

In that case, let us turn to your new page. Your company’s website states that you wish to build a smoke-free future. How should we understand this message from a firm which has been successful in the cigarette business for many years?

I am glad that you find our website interesting. It is true that Philip Morris started as a small tobacco store in London 170 years ago, and has grown into a business which generates 30 billion dollars of net income and owns brands such as Marlboro and Parliament. Against this background, our leadership has unveiled a new mission which will serve to achieve a smoke-free environment. This is a brave step. I cannot think of many other cases where an industry virtually decides to break its traditional line of development at a time when neither the competition nor any other external factors demand it. We believe that after decades and billions of dollars’ worth of investment into research and development, science and technology now allow us to offer adult smokers real alternatives to traditional cigarettes, which can potentially greatly reduce the health risks. This is a very large-scale and significant transformation. First of all, the product itself is being transformed. Then there is the inner transformation: we must transform from a traditional business into one that is characterised by innovative cycles and is essentially closer to the technology business. This requires acquisition of new skills, familiarising oneself with digitalisation, and a faster decision-making process. Finally, there is the outer transformation, which refers to the public perception of our business. If the regulators and the people do not have trust in our company and our products, then we will be unable to transform our industry.

Against this background, where do you see your company in 5 years?

This is hard to say, since the environment is evolving rapidly. However, I think that we will be leaders in this industry. This is the best time to work for Philip Morris. We are becoming considerably more dynamic, and are starting to look much further ahead. Today we understand why it is important to leave a positive mark in the societies and countries where we operate. We now have a much stronger mission.

So, how long will Philip Morris remain in the cigarette business?

If you mean traditional cigarettes, then it would be my wish to see them disappear as soon as possible. However, as I said earlier, this cannot happen overnight and does not depend on us alone. A big role will be played by the government and the legislation in ensuring that the potentially less risky products can be commercialised. On our end, we are making significant efforts to accelerate the transition. We are increasingly shifting resources to the development, assessment, and commercialization of smoke-free products. Though it is hard to predict the timing of such a change, for countries where there is a shared vision, it is possible that we may be in a position to discuss the complete replacement of cigarettes in only a matter of years.

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Juan Carlos Escobar

Born and raised in Spain

Moved to London at the age of 23

Has been working at Philip Morris International for 14 years, recruited from an MBA in Paris

Chose Philip Morris due the company’s values and correct approach towards a controversial industry, and still believes in these today

Has been living in Georgia and managing operations in the Caucasus region and Moldova for the past year.